I’ll be honest — the first time I got employee stock options, I had no idea what they were. Extra money sounded great, but “vesting schedule” and “exercise options” meant nothing to me.
Employee stock options are an excellent benefit, but you need to know what to do with them so they don’t go to waste.
Have you ever wondered, how do stock options work? Read on for a full explanation of this professional benefit.
What are employee stock options?
If you have an employee stock option plan, you can use it to buy shares of your company. These shares will have a fixed price that’s nice and low.
This initial price is called the grant price or the exercise price. It usually matches the market price of a company’s stock at the time the options were granted.
If the company grows, goes public, or gets bought out, then the price of its shares should go up. At this point, you can sell your shares to make a handsome profit. (That’s how many of Google’s early employees became multi-millionaires, including the in-house masseuse.)
However, if the company goes bankrupt, then your shares will most likely be worthless.
How do stock options work?
At first, all you need to do is accept your employer’s offer. The company decides how many shares you get, the price of each share, and the vesting schedule. The vesting schedule determines when you get to exercise your options — in other words, when you get to buy shares.
Most employers don’t let you exercise your options on day one. Instead, you need to work for a year or more first. A typical vesting schedule spans three or four years.
Let’s say your company offers you 6,000 stock options with a three-year vesting schedule. The company says you can exercise one-third of your options after one year (the so-called “vesting cliff”). You can exercise 1/36 of your remaining options each month after that.
Essentially, you can buy 2,000 shares after your first year. Then, you can buy 111 shares each subsequent month until you’ve exercised all of your stock options.
You don’t have to buy shares once your options are vested, but you can if you want to. In some cases, it makes sense to wait on exercising stock options until the value of the shares has gone up.
You should also look into how taxes work on your plan. Employers offer two kinds of stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs).
ISOs are usually better because they have some tax advantages. Check with HR or a tax advisor to learn what tax laws apply to your particular stock option plan.
How can you make money from exercising stock options?
If your company makes money, you make money. How? Let’s again use the example of 6,000 shares.
Let’s say your new job lets you buy those 6,000 shares for $1 apiece. After three years, all your options are vested.
Your super successful company goes public, and suddenly its stock shoots up to $10 per share. If you haven’t already, you buy 6,000 shares at $1 each, spending a total of $6,000. Then, you turn around and sell your shares for $10 each, earning you $60,000.
By spending $6,000 on company stock, you’ve managed to make $54,000! Not a bad bonus after three years of hard work.
Of course, every company is different. Not all companies will end up with valuable stock. In many cases, it makes sense to wait until the market price of your company’s stock exceeds the grant price of your stock options before exercising your options.
Can options expire?
Along with a grant price and vesting schedule, your stock option offer may have an expiration date. You should read your contract carefully for the fine print.
Most companies have a four-year vesting schedule with a one-year vesting cliff. If you leave before a year, you’ll lose your stock options.
But if you leave after the vesting cliff, then you may get to keep any vested options. Some companies give you a window of time to buy shares before they’re lost.
Why do employers offer this benefit?
The financial benefit for you is clear, but what do employers get out of offering stock options?
Well, for one, they make employees feel good. Happy employees are more invested in the company’s success, and thus more dedicated and hard-working. Many skilled professionals expect stock options. The offer can help small companies attract top talent.
Finally, this offer makes financial sense. If companies offer stock options, then they don’t have to pay as much in other benefits up front.
That’s probably why nine times more companies offer stock options today than they did in the 1980s. All in all, offering options is as beneficial to employers as it is to employees.
Don’t ignore this workplace perk
If your new job offers you stock options, make sure to read the details. Figure out how many stock options you get, and what percentage of the company that number represents.
Look for the vesting schedule, tax laws, and any restrictions on exercising stock options. If the market value exceeds the grant price, you should make money. By exercising options and selling shares, you could end up with a serious windfall of cash.
You don’t have to wait for a job to offer you stock options to start investing. If you’re a newbie investor, check out these six brokers to get started.
Are you unhappy with your current job and eager to move on? For more on switching paths, check out this great article!
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